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Even Tame Inflation Couldn't Save the Dow Today

Consumer prices continued their moderate rise, but the stock market is still concerned about what it means for monetary policy going forward.

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

After quickly opening to a decline of more than 200 points early in the session, the Dow Jones Industrials (DJINDICES:^DJI) have floundered throughout today's trading session. Longer-term worries about the state of the economy and the stock market have stolen the spotlight from the large amount of news on the earnings and economic-data front. As of 12:10 p.m. EDT, the Dow is down 188 points.

Still, inflation remains a key component of the Federal Reserve's dual mandate, so it's important to understand the factors that the Fed will look at in assessing consumer prices. With that in mind, let's take a look at the July Consumer Price Index report to try to uncover any useful information.

How did the CPI fare?The headline numbers on the CPI report showed a 0.2% increase in consumer prices in July after the typical seasonal adjustment. That brought the total increase in the CPI over the past year to 2%, which exactly matches the Fed's purported long-range inflation target. Core inflation, which excludes food and energy prices, also rose 0.2% for the month and has climbed 1.7% over the past year.

One concern among inflation hawks has been the jump in energy costs, which have outpaced the overall growth in the CPI recently. Yet the falling prices of electricity and natural gas have offset most of those gains, despite the rise in gas prices, leading to just a 0.2% overall gain in the energy component of the CPI. Meanwhile, food inflation has largely abated, with year-over-year costs rising only 1.4%.

At the same time, though, those who have feared the potential for deflation won't find much reason for concern in the July report, either. Drops in airfares and prices of used vehicles were notable but not particularly troublesome, given their relative lack of overall importance in determining the CPI. For the most part, everything from necessities like clothing and housing costs to more discretionary items like alcoholic beverages showed modest price increases within controlled levels.

Is the CPI spooking the markets?In past months, the CPI's gains have come in below the Fed's 2% annual target rate, so it's noteworthy that we've reached that level in this month's report. With St. Louis Fed President James Bullard having said yesterday how important it is to defend the 2% target, the fact that the CPI has risen by that amount exactly supports the argument that the central bank will be ready to cut back on its bond-buying activity soon. That's likely a big reason that bond yields are rising sharply again today, hitting their highest level in two years at 2.8% for the 10-year Treasury.

The CPI often has a direct impact on interest rates, and it's usually that second-order effect that shows up in stock prices, rather than any direct implications of price increases in particular areas. For instance, Dow component Travelers (NYSE:TRV) is down 1.1% this afternoon, continuing recent declines that have stemmed largely from the drop in value of its bond portfolio following June's big decline in bond prices, which followed the Fed's last major pronouncement about potential "tapering." Banks JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC) have both declined around 1.6% as they, too, will feel a direct impact from interest rate changes. Wider disparities between short-term and long-term interest rates could actually increase their net interest income over time, but it could come at the expense of transactional income from new mortgage lending and refinancing activity.

Yet the CPI also has a much broader effect on the economy. With cost-of-living adjustments for millions of public-sector employees and Social Security recipients tied to the CPI, inflation changes affect available discretionary income, which can have an even larger ripple effect on the consumer economy. Because of that, paying attention to inflation is important not only for your own finances, but for your investments as well.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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